© 2003 McGraw-Hill Ryerson Limited 6 6 Chapter Working Capital and the Financing Decision...
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Transcript of © 2003 McGraw-Hill Ryerson Limited 6 6 Chapter Working Capital and the Financing Decision...
© 2003 McGraw-Hill Ryerson Limited
66Chapt
er
Chapt
er Working Capital and the
Financing DecisionWorking Capital and the
Financing Decision
McGraw-Hill Ryerson ©2003 McGraw-Hill Ryerson Limited
Prepared by:Terry FegartySeneca College
Revised by:P Chua
© 2003 McGraw-Hill Ryerson Limited
Chapter 6 - Outline
What is Working Capital
Management?The Nature of Asset GrowthTerm Structure of Interest RatesShort-Term vs. Long-Term FinancingApproaches to Working Capital Financing Summary and Conclusions
PPT 6-2
© 2003 McGraw-Hill Ryerson Limited
Working Capital Management
Working capital management is financing and controlling the investment in the current assets of a firm
Sales growth often leads to a buildup in inventory and accounts receivable. Firm may require additional external financing
Goal is to achieve a balance between liquidity and profitability that contributes positively to the firm’s value.
Crucial to short-term success or failure of a business
PPT 6-3
© 2003 McGraw-Hill Ryerson Limited
Cash Conversion Cycle
Operating Cycle (OC) consists of that period of time measured by the Inventory Holding Period (IHP) or Average Age of Inventory (AAI) and the Average Collection Period (ACP) of accounts receivable.
Cash Conversion Cycle (CCC) completes the flow of the OC by subtracting the Accounts Payable Period (APP) or Average Payment Period (APP) of accounts payable.
CCC = AAI + ACP - APP
© 2003 McGraw-Hill Ryerson Limited
Cash Conversion Timeline
© 2003 McGraw-Hill Ryerson Limited
Strategies for Managing Cycle
Turn over inventory as quickly as possible (minimizing IHP).
Collect accounts receivable as quickly as possible (minimizing ACP).
Pay accounts payable as slowly as possible (maximizing APP).
© 2003 McGraw-Hill Ryerson Limited
Figure 6-1bThe nature of asset growth
Dollars
Temporary current assets
Capital assets
Time period
Permanentcurrent assets
PPT 6-5
© 2003 McGraw-Hill Ryerson Limited
Figure 6-12Yield curves showing Term Structure of Interest Rates
PPT 6-23
© 2003 McGraw-Hill Ryerson Limited
Figure 6-13Long-term and short-term interest rates
PPT 6-24
© 2003 McGraw-Hill Ryerson Limited
Short-Term vs. Long-Term Financing
Short-term financing is less expensive but riskier lower interest rates (usually) short-term rates are volatile risk of default if sales slow down risk that bank may not extend / renew loans
Long-term financing is more expensive but less risky usually higher interest rates, you may pay interest on funds you don’t always need you have capital at all times
Firm must decide the appropriate “mix”
PPT 6-21
© 2003 McGraw-Hill Ryerson Limited
Figure 6-8Matching long-term and short-term needs (Balanced Approach)
Dollars
Temporary current assets
Capital assets
Time period
Permanentcurrent assets
Short-termfinancing
Long-termfinancing
(debt & equity)
PPT 6-18
© 2003 McGraw-Hill Ryerson Limited
Hedged (Balanced) Approach to Financing Match liquidity (life) of your assets to the maturity (term) of
your financing Means your assets will be generating cash when your
liabilities come due (this reduces risk)
Balanced Financing Temporary (seasonal) build-up in inventory and accounts
receivable finance with trade credit, short-term bank loans, short-term
notes payable Permanent (minimum) levels of inventory, receivables + Property and equipment, long-term investments
finance with long-term loans, leases, bonds, capital stock, retained earnings
PPT 6-17
© 2003 McGraw-Hill Ryerson Limited
Figure 6-9Using long-term financing for part of short-term needs (Conservative)
Dollars
Temporary current assets
Capital assets
Time period
Permanentcurrent assets
PPT 6-19
Short-termfinancing
Long-termfinancing
(debt & equity)
© 2003 McGraw-Hill Ryerson Limited
Dollars
Temporary current assets
Capital assets
Time period
Permanentcurrent assets
PPT 6-20
Short-termfinancing
Long-termfinancing
(debt & equity)
Figure 6-10Using short-term financing for part of long-term needs (Aggressive)
© 2003 McGraw-Hill Ryerson Limited
Plan A Plan B Part 1. Current assets
Temporary . . . . . . . $250,000 $250,000Permanent . . . . . . . 250,000 250,000 Total current assets . . . 500,000 500,000
Short-term financing (6%). . 125,000 375,000Long-term financing (10%) . 375,000 125,000
$500,000 $500,000Part 2. Capital assets
Plant and equipment . . . . $100,000 $100,000Long-term financing (10%) . $100,000 $100,000
Part 3. Total financing (summary of parts 1 & 2)Short-term (6%) . . . . . $125,000 $375,000Long-term (10% . . . . . 475,000 225,000
$600,000 $600,000
Table 6-7Alternative financing plans
EDWARDS CORPORATION
PPT 6-25
© 2003 McGraw-Hill Ryerson Limited
Plan A
Table 6-8Impact of financing plans on earnings
Earnings before interest and taxes $200,000Interest (short-term), 6% $125,000 – 7,500Interest (long-term), 10% $475,000 – 47,500
Earnings before taxes 145,000Taxes (50%) 72,500
Earnings aftertaxes $ 72,500
Earnings before interest and taxes $200,000Interest (short-term), 6% $375,000 – 22,500Interest (long-term), 10% $225,000 – 22,500
Earnings before taxes 155,000Taxes (50%) 77,500
Earnings aftertaxes $ 77,500
Plan B
PPT 6-26
EDWARDS CORPORATION
© 2003 McGraw-Hill Ryerson Limited
Working Capital Financing Plans
A conservative (safe or cautious) firm: L/T financing and high liquidity
A moderate (balanced) firm: S/T financing and high liquidity OR L/T financing and low liquidity
An aggressive (risky) firm: S/T financing and low liquidity
Appropriate strategy is determined based on company’s tolerance for risk
PPT 6-29
© 2003 McGraw-Hill Ryerson Limited
Asset Liquidity
Financing Plan Low Liquidity High Liquidity
1 2Short-term High profit Moderate profit
High risk Moderate risk
3 4Long-term Moderate profit Low profit
Moderate risk Low risk
PPT 6-30Table 6-11Current asset liquidity and asset financing plan
© 2003 McGraw-Hill Ryerson Limited
Summary and Conclusions Working capital management involves the financing and
management of current assets, such as cash, accounts receivable, and inventory
As sales increase, a business requires additional current assets to support the higher sales volume
In a hedged approach to financing, the financial manager tries to time the due dates of liabilities to the receipt of cash from sales
Carrying more long-term debt increases the financing available, but involves a higher interest rate
Carrying more short-term debt may reduces interest costs, but increases the risk of capital shortages
Carrying more liquid current assets improves bill-paying capability, but may reduce potential profits
PPT 6-31